Idiosyncratic mismanagement or a canary in the coalmine?

SVB – The Downfall

The press extensively covered the drivers of the run on SVB (Silicon Valley Bank) and its subsequent collapse. According to Bloomberg News, the Federal Deposit Insurance Corporation (FDIC) – at the time of writing – is in the process of selling the assets of SVB. The federal agency hopes that it will have found a buyer or buyers during these auctions by tonight (Sunday evening) at the latest. The FDIC is seeking to obtain as much cash as possible to distribute to SVB depositors on Monday so that they can pay their employees, vendors and suppliers and continue to operate.

The contours are that SVB had a corporate-heavy deposit mix, concentrated on Bay area tech firms and start-ups, which have been through a period of rapid cash burn. Most of the deposits were not FDIC insured, which made the bank particularly prone to flight. At the same time, the bank had a disproportionate share of assets invested in unhedged long duration high quality credit (Treasuries, MBS, etc.). After the sharp selloff in fixed income last year, their mark to market losses became an absolute blow that sank the ship.

The Big Picture

The first consideration is that SVB is certainly not the only bank to carry big mark-to-market losses.

The picture above (source JPM) shows the breakdown of unrealized losses across the AFS (Available for Sales) and the HTM (Held to Maturity) portfolios in MBS and other liquid fixed income assets. As of the end of Q4 2022, banks in aggregate have accumulated nearly $700bn losses.

Another key macro element is the highly inverted yield curve.

The inversion of the yield curve is now close to revisiting the lowest points touched in the early 80s. While an inverted curve is not necessarily bad for all banks, it becomes a clear stress point for those credit institutions that cannot rely on a stable cheap funding from sticky deposits.

A third pain point for banks is declining deposits.

System wide, deposits declined $420bn since the end of June 2022. This is the by-product of the FED’s QT.

The three elements above will inevitably lead to pressure on NIM (Net Interest Margin). This will be primarily an earning event, but it is hard to see how banks in aggregate will not be able to significantly reduce their loan growth going forward. A certain headwind to growth for H2 2023.

The willingness of Banks to make loans is in clear retreat!

An additional fragility to pay close attention to is the CRE (Commercial Real Estate) exposure, which seems to be excessive for many financial institutions. The table below highlights the banks with outsized exposures to commercial real estates.

Two additional factors signal potential red flags with regards to these commercial real estate exposures. First of all the Maturity Wall. Nearly $92bn of nonbank office debt is set to mature this year.

Second, significant spread widening.

10Y CMBS BBBs Conduits trading in line with CCCs HY bonds.

The two charts above clearly show how CMBS spreads have been recently under intensifying pressure. While broadly may represent an attractive investment opportunity, the grounds is certainly filled with a lot of idiosyncratic landmines. The large CRE exposures that many small-sized regional banks have will likeley lead to credit losses and credit events.

The Short Term Investment Playbook

Positive catalysts in the short term could be:

1 – A depositors friendly resolution of the SVB implosion. Our baseline scenario.

2 – The FED opting for a 25bps hike in the upcoming meeting on the 21-22 of March instead of a more aggressive 50bps hike. Very Likely.

3 – Positive news on CPI/PPI next week. We don’t have a strong feeling here, but at least the average hourly earnings last week gave some indication and hope that maybe wage inflation is cooling off.

4 – However all eyes will still be on SVB, and any delay on an orderly resolution will weigh heavily on market sentiment. The tail risk.

5 – Liquidation vs. reorganization through acquisition also a game changer for bond holders. With the liquidation outcome being obviously the worst case scenario for debt holders. No strong view on view on this. Maybe just a slightly higher chance of an acquisition…

Longer Term Investment Playbook

I have to admit, I am less positive over the longer term.

First of all, the FED finds itself between a rock and a hard place. The highly inverted curve is adding pressure to the smaller non systemic financial institutions.

But there is no good solution to it. Any policy-induced curve steepening, associated with more QT, will be inevitably associated with declining deposits. Not exactly the most desirable outcome under the current circumstances.

Additionally history shows that Banks tend to underperform when the Yield Curve steepens from an inversion. See Chart above. The way out does not seem straightforward.

Second, SVB was probably unique in its vulnerability stemming from losses in its securities book. However, many US banks would have 1/3, 1/2 of their CET1 capital wiped out, should they be forced to realize the losses by a run on deposits.

It is very unlikely to see a repeat of 2008. This is not a solvency crisis as the largest institutions GSIBs are strongly capitalized and incredibly resilient. This time around, the Achilles’ heel is in the space of the smaller, less regulated regional banks. Those are not too big to fail and further consolidation may be in the cards, especially as the FED is still engaged in fighting persistent inflation. SVB is certainly not systemic, but I am afraid won’t be an isolated credit event. The table below, from JPM research, highlights the banks with i) the largest mark-to market losses, ii) declining deposits and iii) high concentration in CRE loans.

Let’s brace for a bumpy road. Small fires seem to intensify and liquidity shocks may become more frequent!

From Bill Ackman

“From a source I trust: @SVB_Financial depositors will get ~50% on Mon/Tues and the balance based on realized value over the next 3-6 months. If this proves true, I expect there will be bank runs beginning Monday am at a large number of non-SIB banks. No company will take even a tiny chance of losing a dollar of deposits as there is no reward for this risk. Absent a system wide @FDICgov deposit guarantee, more bank runs begin Monday am.”

If this is true more short term pressure on risk assets! Please check our Week Ahead for our market strategy updates.

InflectionPoint

Disclaimer

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